A foreign exchange option is an agreement between 2 parties, the purpose of which is to cover a business against the risk of an unfavourable fluctuation in one currency compared to another. This type of agreement is generally concluded over the counter and sets the minimum or maximum exchange rate of a future transaction.
It gives the buyer the right (but not the obligation) to exchange (buy or sell) a certain amount at a fixed exchange rate during a certain period or on a specific date. In exchange for the right to exercise this option, the buyer will pay the seller a premium when the transaction is concluded.
Depending on how the exchange rate moves, the buyer may choose whether or not to exercise this option on the specified exercise date, thereby keeping the possibility of benefiting from a positive movement.
Who is concerned
This is intended for medium or large businesses seeking to limit the risk of future exchange rate variations that would affect their international transactions in foreign currencies, such as:
- exports of goods (raw materials, semi-finished products, merchandise) and services to customers who pay in a currency other than the euro;
- imports of goods and services from suppliers that do not accept the euro as a means of payment;
- purchase of production equipment from a foreign supplier that wants to be paid in a currency other than the euro.
Presentation of the application
Explanation of the underlying financial transactions to the bank.
Some foreign exchange hedging transactions represent a credit risk for banks, causing them to analyse the applicant business and submit the application to the credit committee. It is not, however, customary for the bank to request tangible guarantees for this type of transaction.
How to proceed
In view of the cost and complexity of foreign exchange options, a minimum amount is strongly recommended.
- short to medium-term;
- duration varies from a few days to several years;
- option may be exercised during a given period (American option) or at a specific date (European option).
The premium of a foreign exchange option to be paid by the buyer depends on various factors, namely:
- the exchange rate hedged by the option;
- the market interest rate of the day;
- the volatility of the underlying;
- the duration.
The premium is always paid when the agreement is concluded and may not, under any circumstances, be recovered by the buyer.
Payment of a balancing amount or differential
On the exercise date of the foreign exchange option, the buyer has the possibility of either exercising the option or letting it expire:
- a foreign exchange option buyer who has to pay an invoice in a foreign currency (import) will exercise their right if the exchange rate of their local currency has depreciated compared to the foreign currency in which the invoice is to be paid;
- a foreign exchange option buyer who is expecting to receive payment of a customer invoice (export) in a foreign currency will exercise their right if the exchange rate of their local currency has risen compared to the foreign currency in which the invoice is to be paid.
If the option is exercised, the seller of the option only has to pay the buyer of the option the difference between the reference interest rate and the strike rate.
The reviewing and processing times depend on the complexity, size and urgency of the case.
Advantages, disadvantages and risks
- importing (exporting) businesses are protected against an excessive depreciation (strengthening) of their local currency by a guaranteed minimum (maximum) rate;
- possibility of reversing the transaction at any time given that it is a very liquid market;
- use of the American option if the payment or receipt date is not known in advance;
- makes budgeting easier as the minimum (maximum) amounts to be received or paid are known;
- easy to manage, recorded off-balance sheet for the business.
- the cost of the premium is quite high in the event of major or lengthy fluctuations;
- opportunity cost if the option is cancelled for a new, more beneficial purchase.
The only risk for the buyer associated with an interest rate option is the premium.